How to Calculate and Use the Accounts Receivable Turnover Ratio

No single rule of thumb exists to interpret receivables turnover ratio for all companies. In addition, he can compare the ratio with entity’s own past years’ performance. Receivables turnover ratio is more useful when used in conjunction with short term solvency ratios like current ratio and quick ratio. These short term solvency indicators measure the liquidity position of the entity as a whole and receivables turnover ratio measure the liquidity of accounts receivable as an individual current asset.

1. Cash basis accounting, on the other hand, simply tracks money when it’s actually paid or spent on expenses.
2. This allows for a company to have more cash quicker to strategically deploy for the use of its operations or growth.
3. If you own one of these businesses, your idea of “high” or “low” ratios will be vastly different from that of the construction business owner.
4. Larger businesses can operate with lower ratios because they have more capacity to carry a high level of debt without impacting their cash flow.
5. In general, an AR turnover ratio is accurate at highlighting customer payment trends in that industry.
6. Since you can never be 100% sure when payment will come in for goods or services provided on credit, managing your own business’s cash flow can be tricky.

Also, the average accounts receivable metric used in the calculation may not always be fully reliable. Therefore, taking the average of the period's beginning balance and end balance of a period may not necessarily account for everything in between. Ultimately, the time value of money principle states that the longer a company takes to collect on its credit sales, the more money it effectively loses (i.e. the less valuable sales are). Therefore, a declining AR turnover ratio is seen as detrimental to a company’s financial well-being. The accounts receivable turnover ratio is generally calculated at the end of the year, but can also apply to monthly and quarterly equations and predictions.

With that in mind, let’s learn how to calculate your accounts receivable turnover ratio and how to interpret it. We’ll also cover how to analyze and improve it, allowing you to mitigate the risk of a cash crunch. The accounts receivable turnover ratio, also known as the debtors turnover ratio, indicates the effectiveness of a company's credit control system. Manufacturing usually has the lowest AR turnover ratios because of the necessary long payment terms in the contracts. The projects are large, take more time, and thus are invoiced over a longer accounting period. This can sometimes happen in earnings management, where sales teams are extending longer periods of credit to make a sale.

Limitations of using the receivables turnover ratio

Accounts receivable turnover is an efficiency ratio or activity ratio that measures how many times a business can turn its accounts receivable into cash during a period. In other words, the accounts receivable turnover ratio measures how many times a business can collect its average accounts receivable during the year. The accounts receivable turnover ratio (A/R turnover) is a measure of how quickly a company collects its accounts receivable. It is calculated by dividing the annual net sales revenue by the average account receivables. On the other hand, a low accounts receivable turnover ratio suggests that the company’s collection process is poor. This can be due to the company extending credit terms to non-creditworthy customers who are experiencing financial difficulties.

Formula and calculation of receivables turnover ratio

In some cases, companies use total sales rather than net sales in this calculation. This can inflate the ratio and make it seem as though a company is more efficient than it really is. In most cases, companies perform better by extending more credit to customers, not less, even if this means a slightly higher receivable turnover ratio.

Example of the Accounts Receivable Turnover Ratio

Net sales is everything left over after returns, sales on credit, and sales allowances are subtracted. According to statistics, 20 percent of the time being spent on billing is wasted. To avoid the use of manual labor and to work efficiently, manual billing should be canceled. If you are a business owner, you will always want to run your firm while making money.

When your customers don’t pay on time, it can lead to late payments on your own bills. Unpaid invoices can negatively affect the end-of-year revenue statements and scare away potential lenders and investors. High accounts receivable turnover ratios are more favorable than low ratios because this signifies a company is converting accounts receivables to cash faster. This allows for a company to have more cash quicker to strategically deploy for the use of its operations or growth. Another example is to compare a single company's accounts receivable turnover ratio over time.

The accounts receivable turnover ratio calculates how effectively a company collects accounts receivable (the money a customer owes the company). Another name for accounts receivable turnover ratio is debtors turnover ratio. DSO calculates the average number of days it takes for a company to collect receivables after a sale.

If a company generates a sale to a client, it could extend terms of 30 or 60 days, meaning the client has 30 to 60 days to pay for the product. A company can start rewarding customers for making upfront payments to promote immediate payment. It will also assist the company in determining the customer's payment capability for future engagements.

The Accounts Receivables Turnover ratio estimates the number of times per year a company collects cash payments owed from customers who had paid using credit. We can interpret the ratio to mean that Company A collected its receivables 11.76 times on average that year. In other words, the company converted its receivables to cash 11.76 times that year. A company could compare several years to ascertain whether 11.76 is an improvement or an indication of a slower collection process. For example, if the company's distribution division is operating poorly, it might be failing to deliver the correct goods to customers in a timely manner.

A company may track its accounts receivable turnover ratio every 30 days or at the end of each quarter. In this manner, a company can better understand how its collection plan is faring and whether it is improving in its collections. The accounts receivable turnover ratio is a measure of how quickly a company can turn sales made on credit into cash.

Looking at a company’s ratio, relative to that of similar firms, will provide a more meaningful analysis of the company’s performance rather than viewing the number in isolation. For example, a company with a ratio of four, not inherently a “high” number, will appear to be performing considerably better if the average ratio for its industry is two. The receivables turnover ratio is just like any other metric that tries to gauge the efficiency of a business in that it comes with certain limitations that are important for any investor to consider. An investor or a company owner needs to be aware of the receivables turnover ratio's limitations. When deciding whether or not to invest in a firm, it is critical to understand the limitations of the receivables turnover ratio to make a favorable decision.

As long as you get paid or pay in cash, sure, the act of buying or selling is immediately followed by payment. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. The net credit sales come out to $100,000 and $108,000 in Year 1 and Year 2, respectively.

Like some other activity ratios, receivables turnover ratio is expressed in times like 5 times per quarter or 12 times per year etc. Receivables turnover ratio (also known as debtors turnover ratio) is an activity ratio which measures how many times, on average, an entity collects its trade receivables during a selected period of time. It is computed by sole trader bookkeeping dividing the entity’s net credit sales by its average receivables for the period. Another use is to calculate how many days, on average, it takes a company to collect from its debtors. This is known as the days sales outstanding ratio or accounts receivable days. It can be calculated by dividing the number of days in the period by the AR turnover ratio.

With the income statement in front of you, look for an item called "credit sales." Generally, a higher receivables turnover ratio indicates that the receivables are highly liquid and are being collected promptly. A low turnover ratio may also be caused by the entity’s own inabilities, like following an inappropriate credit policy or having defects in its collection process etc. The most notable difference between these two metrics is https://www.wave-accounting.net/ that the accounts receivable turnover ratio measures only the credit sales aspect of the operating cycle. For example, a company with a high turnover ratio might be very selective, which might mean that they screen the customers very well to ensure timely repayments before extending any credit. A high AR turnover ratio means a business is not only conservative about extending credit to customers, but aggressive about collecting debt.

This is the most common and vital step towards increasing the receivable turnover ratio. Using net sales, in general, would include cash sales which would not fully represent the rate at which companies collect their receivables. This bodes very well for the cash flow and personal goals in the small doctor’s office. However, if credit policies are too tight, they may struggle during any economic downturn, or if competition accepts more insurance and/or has deep discounts. Here are some examples in which an average collection period can affect a business in a positive or negative way.

Our team of reviewers are established professionals with decades of experience in areas of personal finance and hold many advanced degrees and certifications. At Finance Strategists, we partner with financial experts to ensure the accuracy of our financial content. When you know where your business stands, you can invest your time in solving the problem—or getting even better. Since industries can differ from each other rather significantly, Alpha Lumber should only compare itself to other lumber companies. See our examples section below for a comprehensive example that applies this step-by-step process.